chapter 3 the financial information marketplace 3 - 3 mcgraw-hill/irwin money and capital markets,...

Chapter 3

The Financial Information Marketplace

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McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

• To identify important sources of information about the financial system.

• To understand why the efficient distribution of information within the financial system is so important.

• To learn how market participants keep track of the prices of financial assets.

• To learn about the flow of funds accounts and discover what is meant by “social accounting.”

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Introduction

• Sound financial decisions require adequate and reliable financial information.

• We may divide the sources of information relied on by financial decision makers into: debt security prices and yields, stock prices and dividend yields, information on security issuers, general economic and financial conditions, and social accounting data.

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The Great Debate OverEfficient Markets & Asymmetric Information

• The efficient markets hypothesis (EMH) contends that information relevant to the pricing (valuation) of loans, securities, and other financial assets is readily available to all borrowers and lenders at negligible cost.

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• On the other hand, the concept of asymmetric information argues that the financial marketplace contains pockets of inefficiency in the availability and use of information, such that insiders can earn excess returns by selectively trading financial assets based on the special information they have been able to acquire.

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• In an efficient marketplace, each individual investor will rationally use all the relevant information that is available to value stocks and bonds.

• Hence, each financial asset will generate an ordinary, normal or expected rate of return commensurate with its level of risk.

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• If the EMH holds, any temporary deviation of actual returns from expected returns should be quickly eliminated as investors react to temporary underpricing or overpricing of assets.

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Different Forms of the EMH

• The weak form of the EMH argues that the current price of a financial asset already reflects all its price and trading volume history.

• The semistrong form contends that the current price of a financial asset already reflects all publicly available and relevant information.

• The strong form argues that the current price of a financial asset already captures all relevant public and private information.

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Different Forms of the EMH

• Repeated research studies tend to support the weak and semistrong forms of the EMH.

• The strong form, however, has aroused the most controversy, especially because of the existence of insider trading activities and the apparent presence of pockets of special information asymmetrically scattered throughout the financial system.

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Insider Trading & Asymmetric Information

• Insider trading refers to buying or selling a financial asset based on special knowledge or privileges, before that privileged information becomes publicly known.

• Asymmetric information refers to the inequalities in the quantity and quality of information available across different locations within the financial system.

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Problems Informational Asymmetries Can Create

• Lemons and Plums. A loan officer (buyer) cannot be sure without incurring substantial costs whether his or her potential customer (seller) is a lemon (sour) or plum (sweet).

- A mispricing may cause plums to be driven away from the market.

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• Adverse Selection. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers.- Solution: Enable customer signaling via a conditional price

schedule for different account plans.

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• Moral Hazard. One party to a principal-agent contract may decide to pursue its own self-interest at the expense of the other party, often because of poorly drafted contracts or ineffective monitoring activity.- Solution: Draw contracts with the appropriate incentives so that

agents will want to act more in line with the interests of principals.

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Asymmetry, Efficiency, & Real-World Markets

• All real-world markets have elements of both efficiency and asymmetry.

• Perhaps, real-world markets are split into segments: A highly efficient segment in which well-informed individuals

and institutions trade. A less efficient segment in which less-well-informed small

investors trade.

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Informational Asymmetries and The Law

• Some laws and regulations are designed to improve the flow of information between buyers and sellers and to protect the public against deception in valuing financial assets.

• U.S. examples:- 1934 Securities Exchange Act- 1940 Investment Company Act- 1970 Securities Investor Protection Act- Regulation FD (Fair Disclosure), 2000- 2002 Sarbanes-Oxley Accounting Practices Act

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Sources of Information

Debt Security Prices and Yields• Data: bid & ask prices, yields-to-maturity

Sources: real-time computer networks (e.g. Reuters, Bloomberg), televised reports (e.g. CNN, CNBC), financial press (e.g. The Wall Street Journal)

• Data: bond yield indexesSources: Moody’s Investor Service, The Daily Bond Buyer, U.S. Treasury, Dow Jones

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Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, selected issues*2004 figures for January

Indicators of Average Bond Yields(Average Annual Yields in Percent)

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Stock Prices and Dividend Yields• Data: prices (year-high, year-low, day-high, day-low,

closing), sales volume, most recent dividend, dividend yield, P-E ratio, stock price indexes (e.g. DJIA, S&P500, Wilshire 5000), foreign stock prices

Sources: computer networks (e.g. Internet), financial press, television, radio, financial institutions (e.g. S&P, Morningstar)

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Security Issuers• Data: firm history, principal products/services, key officers,

recent operation summary, financial statements, credit ratings, industry performance indicatorsSources: regulatory agencies (e.g. SEC), trade associations, commercial institutions (e.g. Moody’s, S&P, Dun & Bradstreet), directories & databases, journals & magazines, credit bureaus

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General Economic and Financial Conditions• Data: interest rates, money supply measures, industrial output,

international transactions, unemployment rate, inflation, forecasts

Sources: central banks (e.g. the Federal Reserve), statistical bureaus (e.g. Bureau of Economic Analysis), financial press

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Social Accounting Data

• Social accounting refers to the system of record keeping that reports transactions between the principal sectors of the economy, such as households, financial institutions, corporations, and units of government.

• The two most closely followed social accounting systems in the U.S. are the National Income and Product Accounts and the Flow of Funds Accounts.

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National Income and Product Accounts

• The National Income and Product Accounts (NIPA) present data on the nation’s production of goods and services, income flows, investment spending, consumption, and savings.

• In particular, the gross domestic product (GDP) measures the market value of all goods and services produced in the economy within its geographical boundaries.

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National Income and Product Accounts

The Components of the U.S. GDP, 2004* ($ billions, current)

Source: U.S. Dept of Commerce and the Federal Reserve’s Flow of Funds Accounts*Figures are for the first quarter of 2004 and annualized

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Flow of Funds Accounts

• The Flow of Funds Accounts

trace the flow of savings by businesses, households, and governments into purchases of financial assets;

show how the various parts of the financial system interact with each other; and

highlight the interconnections between the financial sector and the rest of the economy.

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• The construction of the Flow of Funds Accounts requires four basic steps:

Sectoring the economy Building sector balance sheets

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© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.3 - 27

Statement of Financial Assets and Liabilitiesfor the Household Sector

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Statement of Financial Assets and Liabilitiesfor the Household Sector

Source: The Federal Reserve’s Flow of Funds Accounts.$ Billions, Outstanding at Year-End *Figures are for Q1 of 2004 & annualized.

… continued

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Sectoring the economy Building sector balance sheets Preparing sources and uses of funds statements

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Sources and Uses of Funds Statementfor the U.S. Banking Sector, 2004*

Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) *Annualized data from Q1.

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Sectoring the economy Building sector balance sheets Preparing sources and uses of funds statements

Building a flow of funds matrix for the whole economy

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Total Net Borrowing and Lending in Credit Markets

Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) **Annualized data from Q1.

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Funds Raised in Credit and Equity Markets

Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) *Annualized data from Q1.

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• Estimates of flow of funds data can be used to help make forecasts of lending, borrowing, and interest rates.

• However, these social accounts do have a number of limitations:- Transactions among economic units within each sector are not

captured.- Flows that occur within the time period under study are not

captured.- The market-value bias of the data distorts actual savings and

investment activity.

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Markets on the Net

• American Economic Association at http://www.aeaweb.org• Comptroller of the Currency at www.occ.treas.gov• Dun & Bradstreet at www.dnb.com• Federal Deposit Insurance Corporation at www.fdic.gov• FINIX European Stock Market Indices at www.finix.at/

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Markets on the Net

• International Monetary Fund at www.imf.org• Investment Company Institute at www.ici.com• Moody’s Investors Service at www.moodys.com• New York Stock Exchange at www.nyse.com• The NASDAQ Stock Market at www.nasdaq.com

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Markets on the Net

• Securities and Exchange Commission at www.sec.gov• The Bond Market Association at www.investinginbonds.com• The Financial Times at www.ft.com• The Wall Street Journal at www.WSJ.com• U.S. Department of Commerce at www.doc.gov/

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Chapter Review

• Introduction: The Importance of Information in the Financial Marketplace

• The Great Debate Over Efficient Markets and Asymmetric Information- The Efficient Markets Hypothesis (EMH)

• What Is An Efficient Market?• Different Forms of the EMH• Insiders and Insider Trading

- The Concept of Asymmetric Information

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Chapter Review

• The Great Debate Over Efficient Markets and Asymmetric Information … cont

- Problems Informational Asymmetries Can Create• Lemons and Plums• Adverse Selection• Moral Hazard

- Asymmetry, Efficiency, and Real-World Markets- Informational Asymmetries and the Law

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Chapter Review

• Sources of Information- Debt Security Prices and Yields- Stock Prices and Dividend Yields- Security Issuers- General Economic and Financial Conditions

• Social Accounting Data- National Income and Product Accounts- The Flow of Funds Accounts

chapter 3 the financial information marketplace 3 - 3 mcgraw-hill/irwin money and capital markets,...

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